Transcript

Introduction

Welcome and thank you for watching "Ashmore's EM in 10'". My Name is Gustavo Medeiros and I am the Deputy Head of Research.

'EM in 10' is a short video designed to cover important events in Emerging Markets.

This week, we will discuss the outperformance of EM assets in May, driven by a faster vaccination pace across most EM countries. We will also discuss inflation, in particular, explain why inflation is likely to remain elevated in the US throughout the rest of the year, and why this won't be a big deal for EM.

Market background

EM assets benefited from a faster pace of vaccination as China is now responsible for more than half of the global inoculations. At the same time, China remains the main vaccine supplier to a large number of EM countries. The Good Neighbour Policy stands in sharp contrast with the attitude of Western countries which opted to hoard vaccines.

EM now is on track to vaccinate 67% of its population by the end of 2021 according to an estimate by UBS. This estimate rose from 30% to just two months ago. For comparison, the projection of DM vaccinations rose to 91% at the end of May, from 72% at the end of March.

Importantly, the Chinese vaccine has proven to be extremely efficient in reducing deaths. A study in Uruguay with 713,000 individuals found that the Coronavac vaccine reduced mortality by 97%, which is in line with the result of previous studies in Brazil and Indonesia.

But even before the vaccine convergence, EM economic activity has been surprising to the upside. In Brazil, first quarter GDP growth came twice higher than consensus, leading economists to review their 2021 forecasts of GDP growth. Economic activity was strong despite a gap in the government paychecks and lockdowns imposed across the country. The median 2021 GDP forecast rose from 3% in mid-April to 5% today. More broadly, the OECD has recently revised its 2021 GDP forecast for EM economies 3% higher, thanks to better-than-expected growth over the last quarters.

May performance

EM large-cap equities rose 2.4% in May, outperforming global stocks. Frontier equities did even better, rising 4.1%. EM large caps was supported by Chinese stocks which rebounded 5% last month, while EM frontier profited from a strong performance in Vietnam, Saudi Arabia, the UAE, Kenya, Kazakhstan, Romania and Slovenia. EM frontier remains a great source of diversification due to its low correlation to large-cap markets.

The best performing market since the beginning of the year however, is EM small cap stocks which rose a whopping 17.1% so far in 2021. Small caps benefited from the recovery of liquidity in the local stock markets, cheaper valuations than large caps and less exposure to China and Hong Kong which represents only 9% of the index versus 40% of the large-cap EM index. EM small caps have historically outperformed large cap over the long term, but lagged over the last three to five years due to the outperformance of tech stocks.

Within EM fixed income, local currency bonds rose 2.5% as EM currencies appreciated 1.9%. EM dollar-denominated debt outperformed US assets as Sovereign bonds rose 1.1% and Corporate was up 0.7%. High yield bonds outperformed investment grade in both asset classes.

US inflation

Looking forward, inflation dynamics will play an important role in both the United States and EM.

The steep increase in US CPI inflation to a year-over-year rate of 4.2% last month should have been expected. CPI inflation is highly correlated with the year-over-year change in commodity prices according to the chart on slide five. The regression is consistent with CPI inflation rising above 5% in May, due to be released on the 10th of June.

Slide six has a scenario analysis which estimates CPI inflation for different changes in commodity prices. The model suggests that CPI inflation may remain above 4% throughout 2021 if commodity prices rise another 30%. If commodity prices remain stable, CPI inflation will gradually decline towards 2% to 3% by the end of the year. If commodity prices decline 30%, CPI inflation would converge towards 2% according to the model.

More concerning is the fact that US inflationary pressures are likely to be broad-based. For example, 44% of all small businesses said job openings are hard to fill in a recent survey in the next slide. This is the highest historical level and highly unusual at the current stage of economic activity. It suggests employers will have to pay higher wages to hire employees in the next months. Furthermore, the widespread disruptions in supply chains and in the labour market stand in sharp contrast with a more buoyant outlook for aggregate demand in the economy over the coming months due to the generous paychecks granted by the US government.

Therefore, the Fed's preferred inflation metric, Core PCE inflation, is likely to remain elevated after rising to a yoy rate of 3.2% in April, the highest level since 1992.

EM inflation

But before we discuss the Fed's reaction to high inflation, let's look into EM inflation. EM inflation has just returned to the average of the five years before 2020, according to the left chart on slide eight. The right chart shows EM inflation rising just above the declining trendline of CPI over the last 10 years, after exceptionally weak inflation last year. We believe that inflation is likely to rise further in the short term due to the increase in commodity prices. However, inflationary pressures are likely to be more benign in EM in the second half of 2021.

Food prices, the most important component across most inflation baskets in EM have been declining in most large countries. Furthermore, several EM central banks such as Turkey, Russia and Brazil hiked policy rates in response to higher inflation. Eastern European central banks are now saying policy rate increases are forthcoming. Tight monetary policy is key to anchor inflation expectations and discourage the pass-through from commodity prices to the economy. More hawkish central banks have been boosting EM currencies, which will help to drive tradable good prices lower.

The Fed & the Dollar

In contrast with the hawkish stance from EM central banks, the Fed has so far kept a dovish posture. Inflation expectations are rising, driving two-year real interest rates to the lowest level ever at minus 2.8%. By opting to remain dovish, the Fed risks de-anchoring inflation expectations, motivating companies to pass higher input prices into their products.

Fed speakers, including Vice Chairman Richard Clarida, have recently mentioned the possibility of tapering quantitative easing in the future.

For now, it seems like the Fed will opt to keep the official line that inflation is transitory. This will drive the dollar lower in our view, as accelerating inflation is likely to keep real interest rates at low levels in the short term.

The chart on slide nine suggests the dollar is overvalued when comparing with the two-year real interest rates. A simple technical analysis, furthermore, suggests the dollar devaluation trend would have more legs if the 1100 price level on the light blue line is broken.

In our view, the Fed should change its policy stance. They could announce tapering at the Jackson Hole convention in August this year. In particular, buying mortgage-backed securities is only adding fuel to the fire in an overheating housing market.

If we are wrong and the Fed decides to double-down on its dovish stance, the dollar sell-off would only accelerate.

No need for a Tantrum

If the Fed tightens however, some investors fear a repeat of the 2013 taper tantrum episode. But this comparison is poorly founded in our view. There are at least five important differences between today and 2013, as highlighted by the next slide, all suggesting EM is in a more resilient place.

First, real rates are likely to remain at very low levels in the US, even if the Fed decides to taper soon.

Second, EM is running a current account surplus of more than 1% of GDP today, compared with a 2% deficit in 2013.

Third, EM currencies are close to their lowest historical levels of valuation, whereas EMFX was relatively rich in 2013.

Forth, commodity prices are rising today, supporting the creditworthiness of EM commodity exporters, whereas commodities were declining in 2013.

Lastly, foreign investors exposure to local markets is much lower today than in 2013.

Summary

In summary, EM assets outperformed in May, driven by a convergence in the pace of vaccinations between EM and DM, thanks to China and thanks to a better-than-expected EM growth. High US inflation and a dovish Fed are keeping real interest rates at their lowest historical levels and the dollar is under pressure. Lastly, EM investors shouldn't fear a u-turn by the Fed as the EM external accounts are healthier than in 2013.

Thank you for watching "Ashmore's EM in 10'". Please do not hesitate to contact us should you have any questions or would like to discuss any matters further.

All the best.